Weekly economic briefing: Australian corporate bond market

The Weekly Economic Briefing is written by two senior Deloitte Economists, David Rumbens from Deloitte Access Economics in Australia and Ian Stewart Deloitte’s Chief Economist in the UK. They provide a personal view on topical financial and economic issues. Subscribe to receive the Weekly Economic Briefing in your inbox!

Australian economic briefing by David Rumbens

This section of the briefing provides a snapshot of key economic data and issues of relevance to Australia.

Australian corporate bond market

The Australian corporate bond market has grown by more than 40% since 2010, currently reaching more than $1 trillion of Australian (financial and non-financial) corporate bonds outstanding. This is more than two-thirds the size of the Australian stock market, according to Deloitte Access Economics’ Corporate Bond Report.

However, direct market participation by Australian investors is currently relatively low compared to other countries: private investors hold less than 1% of all corporate bonds on issue in Australia compared to almost 20% in the United States, and Australian superannuation funds hold only 10% of their assets in bonds and bills compared to an OECD average of 40%.

There’s been growing interest in corporate bond investments from private investors in Australia. Currently, 16% of high net worth individuals (HNWIs – individuals with more than $2 million of investable assets) in Australia have direct holdings of corporate bonds. For the HNWIs that own corporate bonds, this asset class represents an average of 11% of their total portfolio – the fourth highest investment allocation behind property, cash and shares (Chart 1). Private investors who do not own corporate bonds have a much higher proportion of their assets allocated to investment property.

Chart 1: Average asset allocations of HNWIs’ investment portfolios

Source: Deloitte Access Economics survey (2018)

As a fixed income asset, corporate bonds provide capital stability and regular interest payments. But they offer higher yields than other fixed income securities such as government bonds and deposits, in order to compensate investors for the additional risks associated with corporate issuers. Around three-quarters of HNWIs with corporate bonds believe they provide a reliable income stream and relatively good returns given the risk profile.

But a lack of understanding of the role and features of corporate bonds continues to be a barrier to investing by both private and corporate investors in Australia. Almost 70% of HNWIs without corporate bond holdings have insufficient understanding to feel comfortable investing in corporate bonds (Chart 2).

Chart 2: Level of understanding of corporate bonds as an investment

Source: Deloitte Access Economics survey (2018)

Going forward, there is clear potential for growth in the Australian corporate bond market. For example, Australia’s population is ageing, with the number of Australians aged 65 years and over forecast to increase to almost 5.7 million by 2030. Corporate bonds can be well-suited to the investment preferences of private investors transitioning to retirement, as retirees rely on accessing a predictable and stable income stream from their investments, and have a lower tolerance for risk and volatility. More investors transitioning to retirement will create future opportunities for corporate bond demand.

Overall, future investment intentions suggest that the share of HNWIs in Australia that own corporate bonds could increase from 16% to 29% over the next 12 months, illustrating that investors see potential in corporate bond investments. Ongoing market innovations and new funding products will continue to support this growth over the coming years.

UK economic briefing by Ian Stewart

The changing size of the state tells the story of modern nations and the ideas that shape them.

Until the late nineteenth century the civilian state scarcely existed. In 1692, when comprehensive records for what was to become the UK started, civil spending by government came to a modern equivalent of around £90 million. A country that was about to acquire a vast empire was governed with a budget equivalent to that of today’s Food Standards Agency.

For most of the last three hundred years, waging war was the main item of spending for government. Public spending and borrowing fluctuated in line with the wars Britain fought, becoming progressively more costly with the mobilisation of whole societies in the twentieth century.

The Napoleonic Wars started in 1798 and were the most costly of any before the twentieth century, briefly pushing government spending as a share of GDP from single digits to 20%. The First and Second World Wars were all-encompassing and, for the duration, were the principle business of Western economies. In the UK, government spending ended up accounting for nearly 60% of GDP in each conflict.

Until the mid-nineteenth century most government revenues came from purchase and customs taxes levied on a wide range of items including wool, coal, windows and land. Income tax was introduced as a temporary expedient, at low rates, in 1798, to fund the war with France. With neither the infrastructure of modern taxation nor the public acceptance of high taxes, the UK government relied more on debt to finance the Napoleonic Wars than in the First or the Second Wars.

Thus, the burden of UK public debt as a share of GDP peaked at far higher levels after the Napoleonic Wars than in the wake of the First or the Second World Wars.

Waging war inflicts far more damage on a nation’s finances than countering a deep recession. The UK’s debt-to-GDP ratio has risen in the wake of the financial crisis and stands at 87% today, up from 41% in 2006, but still a fraction of its post-war highs.

Outside of wars government spending in the UK in the last hundred years has been dominated by the growth of civil spending on schooling, health and welfare. Behind this lies a revolution in ideas associated with the rise of the labour movement, the extension of the franchise and the prosperity and social ills wrought by the Industrial Revolution.

In Britain the civil state started its great expansion in the Edwardian period and saw its apotheosis in creation of the welfare state between 1945 and 1951.

When the state was small the ups and downs of the economic cycle and financial crises had little effect on the public finances. The South Sea Bubble in 1720 and the Railway Mania crashes of the mid-nineteenth century had no impact on public borrowing.

A permanently expanded role for the state has made public spending, revenues and borrowing more dependent on the economic cycle. The work of the British economist, John Maynard Keynes, in the 1930s, entrenched the idea that government should counter recessions through borrowing and spending more. In the last 70 years recessions, rather than wars, have tended to be the main driver of borrowing with deficits increasingly common.

Yet over time, public debt levels have come down in the wake of war and recession. History is encouraging in this respect. It took 80 years, but by the early 1990s the ratio of public debt to GDP in the UK was down to levels last seen on the eve of the First World War. Those who worry about the current level of indebtedness of the UK government might take some comfort from the fact that the UK ran far higher levels of debt through much of the last three centuries.

So historically public debt comes down. The real question is who pays to reduce it?

The extreme option is for a government to default on its debt, so the lender foots the bill. This, of course, has much wider consequences, undermining economic stability and confidence in the rule of law as well reducing the ability of the government to borrow in the future. Governments that have a history of defaulting on their debts pay more to borrow than those that don’t.

In practice it has tended to be a combination of the public and bond holders who bear the cost of reducing debt levels. The public pays more taxes and they may get fewer public services. Bondholders can lose out through higher inflation, which reduces the real value of the debt they have bought from the government. That’s good for the government, because it reduces the burden of debt, but pretty dire if you’ve lent money to the government (though not as bad as the government defaulting).

Government is a far larger and more important player in the economy than when UK data on spending and borrowing first started to be collected in the 1690s. But the essential choices remain the same. Someone has to pay for debt-financed spending. The distribution of that cost, how equitable it is and how orderly the process, these judgements lie as much in the realm of politics as economics.

OUR REVIEW OF LAST WEEK’S NEWS

The FTSE 100 ended the week down 0.5% at 7,737.

International economic briefing by Ian Stewart

Economics and business

France’s fiscal deficit is now in compliance with EU budget rules having fallen below the EU’s 3% ceiling for the first time since 2007

The European Central Bank (ECB) warned the euro areas more indebted economies that, loosening fiscal policy may cause investors to sell their bonds

The ECB published its plan for ‘sovereign bond-backed securities’, a package of bonds issued by different member states bundled together

The European Commission said, “Italy needs to continue to reduce its public debt [of 132% of GDP] which is [the] second highest in the EU after Greece”

A smaller proportion of UK workers are on low pay (now earning less than £8.50 an hour) than at any time since 1982, according to the Resolution Foundation

Shadow Chancellor John McDonnell said businesses should be required to share profits with workers and that businesses would get a ‘fair rate of return’

66% of UK manufacturers and 60% of services firms are struggling to find suitably skilled staff, according to the British Chambers of Commerce and DHL

UK inflation fell unexpectedly to 2.4% in April, down from 2.5% in March

UK retail sales rose at a monthly rate of 1.6% in April as warm weather brought shoppers back to the high street

Turkey’s central bank raised interest rates to 16.5% from 13.5% in an attempt to halt the Lira’s rapid decline

Activity in Japan’s manufacturing sector slowed to a 9-month low in May, according to purchasing managers’ data

China agreed to cut import duties on US automobiles in exchange for the US reversing sanctions on struggling Chinese telecoms equipment maker ZTE group

US congress is working on legislation to further restrict Chinese investment in the US

UK home ownership rose last year for the first time in 13 years

Deutsche Bank is to cut 7,000 jobs as part of its restructuring plan

Brexit and European politics

The Times reports that Prime Minister Theresa May will ask the EU for a second Brexit transition period until 2023 to avoid a ‘hard’ Irish border

Bank of England Governor Mark Carney said UK households were now £900 worse off due to Brexit than would otherwise be the case

Mr Carney said the Bank is ready for Brexit, and in the event of a disorderly outcome, it may have to accept higher inflation to avoid a downturn

Italian President Sergio Mattarella asked ex-IMF economist Carlo Cottarelli to form a temporary government after efforts by Italy’s two populist parties to form a government collapsed. New elections are expected by early next year

The Italy-Germany 10-year bond spread has risen 80 basis points over the last month as political uncertainty in Rome buffeted markets

91% of German companies invested in the UK do not intend to relocate, according to a survey by the German Chamber of Commerce and Industry

UK-Ireland trade could fall by 10% after Brexit as a result of non-trade barriers such as paperwork, according to the Central Bank of Ireland

A so called maximum facilitation customs border with the EU could cost up to £20bn, around twice the UK’s net annual contribution to the EU budget, according to the head of HMRC

A YouGov poll found that the percentage of British voters who view immigration as one of the UK’s most important issue fell to 29% from 56% before the Brexit vote

Approval ratings for the EU in member states are at their highest level in over a decade, according to Eurobarometer

Scotland’s first minister Nicola Sturgeon said there will be another vote on independence once “the future relationship between the UK and the EU is clear”

And finally…

Residents in the Florida city of Terminus received a text message from city government warning of a power outage “due to extreme zombie activity”. City officials later issued an apology for the bogus alert and insisted that “Lake Worth does not have any zombie activity” – Supernatural Message Service

David Rumbens is a Partner within Deloitte Access Economics. He is a macroeconomist with extensive experience in applied economic and quantitative analysis of the Australian economy, along with considerable experience in labour market analysis.

Ian Stewart is a Partner and Chief Economist at Deloitte where he advises Boards and companies on macroeconomics. Ian devised the Deloitte Survey of Chief Financial Officers and writes a popular weekly economics blog, the Monday Briefing. His previous roles include Chief Economist for Europe at M...

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